The U.S. Dollar and the World Economy: A Critical Review

[Pages:24]Athens Journal of Business & Economics - Volume 6, Issue 1 ? Pages 21-44

The U.S. Dollar and the World Economy: A Critical Review

By Kalim Siddiqui*

The relative decline of the U.S. as a global economic power is clear, and can be seen in the statistics. However, the U.S. decline is nevertheless a slow one, and carries all sorts of unprecedented dangers for the world. The U.S. is definitely in a less powerful position than previously with respect to production, but it is still successfully siphoning off much of the economic surplus (or surplus value) created in the developing countries via the operations of its multinational corporations and its hegemony over the global financial architecture. With respect to U.S. financial dominance, the key issue becomes the continuation of the dollar as the hegemonic currency, which is currently threatened by the rise of China. This paper intends to critically analyse the performance of the U.S. economy and also the role played by the U.S .dollar in the international payment and in reserve currency. The study will also examine the expansion of Chinese economy and importance of the gradual development of a multicurrency system with the intention of reducing the growing balance of payments deficit putting pressure on a single reserve currency. This study has followed doctrinaire methodology, which includes analytical, descriptive and comparative methods. This article concludes that the U.S. economy is currently suffering from a serious trade deficit and the position of the U.S. dollar is under genuine threat from the renminbi, the renminbi will not be able to replace the U.S. dollar as the global currency for at least the next decade. (JEL E50, 60, F30, G15)

Keywords: World Economy, U.S. Dollar and the Renminbi.

Introduction

The relative decline of the U.S. as a global economic power is clear, and can be seen in the statistics. However, the U.S. decline is nevertheless a slow one, and carries all sorts of unprecedented dangers for the world. The U.S. is definitely in a less powerful position than previously with respect to production, but it is still successfully siphoning off much of the economic surplus (or surplus value) created in the developing countries via the operations of its multinational corporations and its hegemony over the global financial architecture. With respect to U.S. financial dominance, the key issue becomes the continuation of the dollar as the hegemonic currency, which is currently threatened by the rise of China. (Wade 2017, Economist 2015) The U.S. share of the global domestic product is estimated at less

*Senior Lecturer, Department of Accounting, Finance and Economics, University of Huddersfield, UK.



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than 20%, while U.S.-based companies control about half of the worlds wealth (World Bank 2017).

Of course, these facts show us a very complex picture of the contemporary world. A recent study by Bullard et al. (2017) points out that the U.S. economy is still the worlds largest economy and, according to them, between 2008-15 there was an average annual shortfall of 20% in fixed capital investment due to the 2008 crisis, which adversely impacted on GDP growth by an average of 10% (Bullard et al. 2017). Needless to say, the U.S. has by far the largest military in the world. It controls ? largely through the role played by its military sector in technological development ? the most advanced technologies in the world (Harvey 2005).

For major G7 economies, the average growth rates experienced were all over 3% between 1960-80; however, in 2016-17, U.S. growth was 1.7%, the Eurozone area saw 1.8% growth, and Japan, 1.1% (World Bank 2017: 4, Table 1.1). Wien (2010) commented about the U.S. economic decline in key areas like, the "return on investment" from an estimated 15% in the post-war period to 10% by the end of the 1980s; by the end of 1990s, it was said that the return was only "5 percent and few would put money at risk for that reward" (Wien 2010).

This paper intends to examine the performance of the U.S. economy and also the role played by the U.S. dollar in the international payment and in reserve currency. The U.S. dollar is, at present, the dominant reserve currency of the countrys central banks. The U.S. Treasuries market is the most liquid financial market in the world, which makes Treasures an attractive investment for holding central bank reserves. The U.S. dollar is also the dominant currency for invoicing international trade and is also used in denominating the majority of foreign debt securities (Fine 2013). The study will also examine the expansion of Chinese economy and importance of the gradual development of a multicurrency system with the intention of reducing the growing balance of payments deficit and lessening of pressure on a single reserve currency. A multicurrency reserve would even help developing countries to diversify their foreign exchange currency holdings; hence, should a country accumulate a huge amount of U.S. dollars and find that confidence in the dollar declines, then they can merely switch to other reserve currencies. This reduces the demand for single reserve currency.

This paper also aims to analyse the Chinese currency and its potential to become an international reserve currency. However, China needs to improve the efficiency of its financial sector and financial market (Subacchi 2016). The challenges will be whether increased demand for the renminbi would lead to its appreciation and consequent loss of export competitiveness in the global markets. This study has followed doctrinaire methodology, which includes analytical, descriptive and comparative methods. The research is drawn from the use of past documents to understand the subject area and in the process it becomes evident that the methods utilized depend not only upon the researchers perspective, but also on the time and available resources.

The relative strength of the U.S. economy supports the value of its currency. In fact, this was an important reason for the US dollar emerging as the most powerful currency after World War II. At the end of the World War II, the US accounted for half of the worlds GDP and with Europe and Japan destroyed by

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the war, the US was the only country with a developed manufacturing sector to produce goods needed by the consumers. As Western Europe and Japan began to recover from the war, the US relative economic strength started to decline. By the 1980s, West Europe and Japan caught up with the US in the terms of productivity. In the 1990s, the dominance has remained due to the rising amount of US dollar debt owed by domestic and foreign borrowers and creditors in countries in the rest of the world.

Despite the slowdown of the U.S. economy in recent decades, more than onethird of the world's gross domestic product still comes from countries that peg their currencies to the dollar; indeed this includes seven countries that have adopted the U.S. dollar as their own. Furthermore, more than eighty-five countries maintain their currencies in a tight trading range relative to the dollar. In fact, the U.S. GDP makes up only 25% of the global GDP and U.S. trade volume in only 15% of the worlds total trade in 2017. But still the U.S. dollar remains the predominant currency used in world trade and financial transactions. For example, the U.S. dollar makes up nearly 63% of central banks reserve currency holdings, against 17% for the euro and 2% for the yen (Siddiqui 2018a, World Bank 2017). In the foreign exchange market, 90% of forex trading involves the U.S. dollar. The dollar is of course just one of the world's currencies, but most of these currencies are only used inside their own countries. Theoretically, any one of them could replace the dollar as the world's currency, but this is unlikely as they are generally not widely traded. At present, nearly 40% of the world's debt is issued in the U.S. dollars (World Bank 2017, Willett and Chiu 2012).

The history of international reserve currencies shows that there is a tendency in the past for one currency to dominate global trade and finance, and any change to the status quo is often reflected in shifts in its economy and global power politics (Harvey 2005). This means that there has been a strong incentive to choose a currency that other trading countries are able to accept and use for international transactions. However, a dominant currency can lose its hegemony to another due to changing economic and political dynamics. For example, the British Pound Sterling was a leading international currency before World War I ? more precisely between 1860 and 1914 ? when more than 60% of world trade was invoiced and settled in Pounds Sterling, and a similar trend was seen in the holdings in the global foreign exchange reserve. Once Britain became colonial power, it encouraged colonial administration to use Pound Sterling and thanks to the associated favourable policy of support, Sterling then flourished. (Kaldor 1971) In 1914, Britain stopped using the gold standard but returned to it in 1925 at a prewar parity under pressure from British financial capital, which wanted such parity; at that time, Britain had colonies to support such moves, but such alternatives were not available after the war, so the Pound Sterling was over-valued and Britain started facing balance of payment problems. To extricate itself from this, Britain imposed wage deflation and reduction in domestic absorption on its workers so that its exports would be cheaper and imports more expensive. The then strong trade unions did not accept this and called for a general strike in 1926, soon after Britain returned to gold standard. The current situation differs from earlier periods

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because the advanced economies do not have direct colonial possessions (Siddiqui 2019b).

In the beginnings of World War I, the balance of Sterling accounted for less than half of total official foreign exchange holdings, while the French Franc accounted for about a third and the German Mark about one-sixth. Between the 1920s and 1930s, these two currencies (Pound and Franc), along with the U.S. dollar, dominated the demand for international reserve currencies. Historically, very large UKs current account deficits have been sustained for long periods of time, as seen during the late 19th century. The UK was also exporting huge amounts of capital to countries such as Australia, Canada and Argentina. Some critics were worried that UK investors were lending and exporting capital at the neglect of the domestic markets. This was primarily due to the lack of higher returns in the domestic economy (Siddiqui 2019a, Kaldor 1971).

During World War I, the UK economy understandably experienced a deep crisis and its current account and fiscal deficits and external debts rose sharply. These developments affected the British Pound adversely. Soon after World War I, the U.S. dollar took over as the leading international currency, but it was not until end of the World War II (i.e., 26 years later) that the dollar became the dominant international currency, replacing the Pound Sterling as the principal international currency (Kaldor 1971). At present, similar situation can be seen in the U.S. economy, where the U.S. trade share in the global economy has declined significantly; nevertheless, other countries are still using the U.S. dollar as an invoicing currency, which keeps the ex-post prices of goods similar to those of its competitors, and further provides hedging benefits. Safe heaven depositors have not been influenced by recent developments in the US economy, even after the Standard and Poor downgraded the US credit ratings in August 2011.

Currently, the U.S. economy is experiencing deep structural difficulties. The question facing other countries governments now is whether they will go on buying and holding U.S. securities in large amounts. For more than six decades the U.S. has maintained its financial hegemony (Fine 2013), where no other asset was seen as attractive as U.S. dollar by the overseas investors; however, things are now changing, with the Eurozone, for instance, providing as large a liquid market as the U.S. The Euro economy is the same size as that of the U.S., but at present accounts for a larger share of world trade.

Since the euro emerged as the single currency of the Eurozone countries, a single euro has consolidated, rather than fragmented, national currencies (prior to 1999). It seems the euro has emerged as a second important useful currency to be used as a reserve by the countrys central banks. In 2010, the euros share as a reserve currency was 26%, as compared to 61.8% for the U.S. dollar for the same year (Siddiqui 2019b). In 2010, East Asian currency traders conducted 93% of their transactions in foreign exchange markets, as these markets also happened to have seen the largest shares in global growth. All these factors have boosted the demand for U.S. dollars (Wolf 2008, Harvey 2005).

Further, in reference to debt, the U.S. official indicates that as a share of GDP, U.S. debt has greatly increased in recent years. The proportion of debt to GDP may drop due to government surplus, inflation or growth in GDP. As of October

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2018, the US public debt stood at $15.8 trillion; at the same time, intragovernmental holdings stood at $5.8 trillion. Further, in 2017, U.S. debt was about 77% of its GDP which was the 43rd highest in the world. By 2028, the ratio would be 100%, or even higher if present policies will be extended past the scheduled expiration date. Further, by December 2017 45% ($9.3 trillion) was held by foreign investors, with China having the largest share of $1.18 trillion, followed by Japan at $1.06 trillion. (OECD 2019, Willett and Chiu 2012)

The use of the U.S. dollar as an international reserve currency heightens the so-called Triffin dilemma. With increasing trade there are also demands for international reserve increases. Hence, the reserve-issuing country needs to continue to run a balance of payments deficit in order to meet the increasing demand for its currency; as a consequence, the reserve-issuing countrys external debts rise sharply. According to the researchers, an international currency must satisfy three key criteria, which are: medium of exchange, unit of account, and store of value (Patnaik 2009). In the short term, it appears that the U.S. Dollar and euro are likely to remain the dominant international reserve currencies. The greatest challenge is currently seen to be a lack of dynamism within the eurozone economy, and it is unlikely the euro will ever represent an alternative to U.S. Treasury, also in part due to the eurozones current economic crisis, especially in the southern EU countries. The Japanese yen, which had high levels of foreign exchange reserve of 8% in 1990, soon declined due to the long-term stagnation of the Japanese economy; in 2010, the reserve in the yen was merely 3.7%.

The Chinese renminbi could emerge as the new international currency with the countrys growing economy and trade. The Chinese economy has increased its share in the global economy. In the coming decades, it is hoped that Chinas economy will take over that of the United States. China has increased reliance on international trade, with both its exports and imports consistently rising; it is expected that its trade will grow further in the future. Chinas export baskets include manufacture products and its currency could be used for global exchange.

Flexible exchange rates and free capital movement have been unable to keep the world economy stable. The emerging economies have built up massive foreign exchange reserves principally in order to protect themselves from panic capital withdrawals (Siddiqui 2018b), as seen during the 1997 East Asian crisis and again after the 2008 financial crisis. Such sudden withdrawal of capital proved to be costly in terms of their investment, economic growth and overall development. This uncertainty also adds to global imbalances. Lee (2014: 43) noted: "The fast growing economies of developing Asia are providing an important source of global production and demand. Asias emerging and developing economies maintained an average annual growth rate of 6.8% over 2000-10. In 2010, Asia (including Japan) accounted for about 27% of global GDP, up from mere 12% in 1960. By comparison, in 2010, the United States contributed 23.1% and the European Union (EU) 25.8% to the world GDP".

The emerging economies have kept reserves in dollar denominated assets. The continuous rise in foreign reserves in foreign countries has led to an increase in demand for U.S. financial assets, which is tied to the ever-rising inflow of funds into the U.S. financial system from abroad, which encourages asset prices bubbles;

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also, excessive reserve accumulation overseas is due to developing economies trying to self-ensure against possible speculative currency attacks. This caution is due to the East Asian crisis of 1997, and the desire to guard against sudden investment collapse or to keep currency from appreciating as this could adversely affect export competitiveness (Wade 2017). A large number of emerging market economies borrowed heavily in dollars when American interest rates were at rockbottom levels (Huang and Kishor 2019, Siddiqui 2017). The result was creditdriven growth, which starts to look fragile when ? as now ? the Federal Reserve is raising interest rates and the U.S. dollar is strengthening (Siddiqui 2018c).

Despite some of these countries efforts to build-up foreign exchange reserves over the past decades, the shortages of US dollars as capital inflows into these economies resulted in a reversal of capital flows into developed economies. All these developments led to an increased cost of borrowing in the dollar. The Stiglitz Commission (United Nations 2009) argued for the creation of a new global reserve system based on Special Drawing Rights (SDRs). The Commission report recommended that during recession the role of the SDR should be increased through IMF lending to those countries in need of short-term finance (Stiglitz and Greenwald 2010).

Since the 2008 crisis, the interest rates in the advanced economies have been maintained at almost zero levels in order to revive their economies, which meant that the flow of capital from their economies to the emerging economies became more profitable. Such capital flows have taken the form of equities and loans. Therefore, if the currencies in emerging economies depreciate, then asset holders from the advanced economies will be affected (Siddiqui 2016a,b). Any depreciation of the local currency will thus start panic and result in capital flight from the emerging economies. This means international capital is not interested to see depreciation take place (Patnaik 2009).

Performance of the U.S. Economy

The current account provides an overview of transactions between a country and its foreign trading partners resulting from the purchase and sale of goods and services produced in the current period. If the United States has a current account surplus, this means that America is selling more goods and services to foreign markets than they import goods purchased from foreign markets. Typically, since 1996, the U.S. has a negative current account balance, or current account deficit (See Figure 1), while, Germany, Japan and China have current account surplus. When there is a current account deficit, the United States must borrow the liabilities to pay for goods and services purchased from abroad. The external debt rises as a result of current account deficits. However, exchange rate changes may not be adjusted according to the direction of balance of payments. If the current account is in deficit but there is also a large amount of capital inflow in capital account surplus, the currency will not devalue but will rather appreciate, thereby exacerbating the balance of payments deficit. If the balance of payments deficit is caused by a current account deficit, it will inevitably lead to fewer jobs in export-

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related sectors and a downturn in the economy. If the balance of payments deficit is caused by capital account and financial account deficit, however, this would mean a lot of capital outflows and a tight supply of domestic capital, which would result in a rise in interest rates and a decline in the economy.

According to Amadeo (2018), the main contributors to the deficit are consumer products where, in 2017, the U.S. imported consumer products worth $602 billion, while exports totalled $198 billion. This could be explained by the decline in competitiveness of U.S. products which was largely the result of the devaluation of the Chinese yuan, making Chinese products cheaper than U.S. products. In an effort to bridge this gap, President Trump enacted his policy of protectionism measures (Siddiqui 2018a), in particular imposing tariffs against the imports from China and Mexico (Amadeo 2018).

Figure 1. Current Account Balance, Total, % of GDP, 1996 ? 2018 (Source: Main Economic Indicators: Balance of Payments)

Source: OECD Retrieved from [Accessed 10 February 2019].

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Figure 2. United States Long Term Interest Rates, Total, % per Annum, May 1998November 2018

Source: OECD Data. Retrieved from [Accessed 10 February 2019].

Figure 3. Real GDP Long-term Forecast, Total, Million US Dollars, 2020 ? 2040

Source: OECD Economic Outlook: Statistics and Projections: Long-term Baseline Projections. Retrieved from . [Accessed 2 March 2019].

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